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This paper provides a new explanation for the dominance of the low-powered incentive contract over the high-powered incentive contract using a mixed model of moral hazard and adverse selection. We first show that the power of incentives in the second-best contract is lower than that in the first-best contract in the presence of either unobservable risk aversion or cost. We then consider the case that both risk aversion and cost of the agent are unob- servable to the principal. We solve this multidimensional mechanism design problem under two assumptions with regard to the structures of performance measurement system and wage contract. It is shown that if the deterministic and stochastic components of different per- formance measures vary proportionally, the principal is inclined to provide a low-powered incentive contract. Moreover, it is shown that if the base wage depends only on a quadratic function rather than the direction of the performance wage vector, no incentive is provided for most of the performance measures in an orthogonal performance measurement system.

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